Local Lending Markets: What a Small Business Owner/Manager Needs to Know

Blackwell, David W., Winters, Drew B., Quarterly Journal of Business and Economics

David W. Blackwell [*]

This paper is a clinical examination of local lending markets served by two bank holding companies. Using small business lines of credit, we find evidence of higher average rates in the less competitive markets and less responsiveness of interest rates to the strength of the relationship between the borrower and the bank in the less competitive markets. These findings suggest that even after the dramatic changes in the banking industry over the last 20 years, the small business owner/manager still faces interest rates driven by local market competition. In our conclusion, we offer some suggestions about how the small business owner/manager may be able to gain access to more competitive loan rates.

Introduction

Berger and Udell (1998) report that the primary sources of small business funding are the principal owner, trade creditors, and commercial banks. They present a life cycle for small business funding that begins with all funding from the principal owner and that shifts toward funding from trade credit and bank loans as the firm grows and ages. Berger and Udell note that as small firms access external debt the owner often is required to pledge personal assets to support the debt because small firms are often informationally opaque. Because of the wealth (personal and business) that the small business owner has at stake, it is important that the small business owner understand the market for bank credit to small businesses.

Existing evidence suggests that developing a relationship with a bank is valuable to a small business. Petersen and Rajan (1994) find that the length of firm's primary banking relationship is positively related to the amount of credit available to a small business, while Berger and Udell (1995) find that the length of the primary banking relationship is negatively related to the cost of debt to small firms. The value of banking relationships for small firms must be tempered, however, by Hannan's (1991) findings that lending markets are local (geographically limited) with higher average loan rates in the less competitive markets. [1] In addition, Petersen and Rajan (1995) find that small firm loan rates decline more slowly in markets with less local banking competition. Because the value to small businesses of banking relationships is related to local banking competition, a logical question is whether consolidation of the banking industry, ongoing since the late 1970s, has affected local lending competition. [2] The answer to this question lies on two dimensions: the quantity and pricing of credit in local banking markets.

As the banking industry consolidates, one concern for small businesses is that large banks may be less able or less willing to lend to small firms. Peek and Rosengren (l998a) examine the share of a bank's loan portfolio allocated to small business loans. They do not find evidence to suggest that the amount of small business loans has declined with the consolidation of the industry. In fact, they find that in about half the mergers they study, small business lending increased in the period immediately following the merger. Berger, Saunders, Scalise, and Udell (1998) also find that the consolidation of the banking industry has not reduced the amount of small business lending. This suggests that small business owners continue to have access to bank loans for their businesses--but at what cost?

Meyer (1998) suggests that bank mergers are mostly market extension mergers, so they do not increase local market concentration. Instead, Meyer suggests that market extension mergers may increase local market competition. Given the findings of Hannan (1991) and Petersen and Rajan (1995) that local lending markets are based on the amount of local competition, Meyer's suggestion of increased competition means that more competitive loan rates may be available to small businesses as banks merge. This is the issue examined in this paper. …

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